Market commentary - 3/31/20
We began 2020 with resolution of many of the geopolitical situations that had dominated the 2019 headlines, including US/China trade negotiations. While some other areas of the world were struggling, the US economy was relatively robust, supported by a fully employed population with rising wages. Equity markets marched higher, supported by a strong corporate and consumer America, as well as, an excessively easy monetary policy. This all changed in March, as economic activity was halted, and the markets dropped at epic speed and proportions. The US government has responded with historic rescue packages, but has still left everybody wondering…will it be enough?
As the coronavirus made headlines in January, many assumed there was a risk we could see some impact of spread, but that it would be contained. Many believed our economy was so robust that it could certainly absorb a minor disruption. When the virus hit our shores, discussion of a short-lived interruption and a V- or U-shaped recovery emerged.
Despite heading into this situation with broad-based economic strength, the virus has taken a deep hold, and the degree of shut downs in the US and around the world have been greater than anyone imagined. Also, shutdown timelines continue to be extended. The US economy will not regain its footing for months from now, which is certainly longer than we first imagined. Recovery will be a slow process.
The consequences are significant with sectors looking at permanent damage, although others will benefit. Overall, it will take time to recover from the adverse economic impact. The prospects of the V-shaped recovery, or the U for that matter, have been severely diminished. We are looking at possibly an elongated U, but more likely a hockey stick with a flatline for a few months until communities, counties and eventually states and the country incrementally come back on line.
With that said, this pandemic is occurring on the back of a decade of robust domestic growth and prosperity. Our economy has provided a solid foundation to absorb this temporary hit, and ultimately resume long term growth. However, the length and breadth of this economic pause remains unknown.
The government response has been huge and necessary, but it addresses solvency rather than a return to profitability. The response is a “rescue package”, not a “stimulus package”. In fact, some of the elements of the Fiscal package such as unemployment benefits may prolong the return of workers post crisis, depending on its duration.
Significant declines in economic data are on the horizon, and they will be severe beyond any historical comparison, with expectations that GDP will be down 10-20%, and unemployment up to 10-20%. Millions have submitted claims for unemployment. In the coming months, markets will wrestle with what is priced in versus what is actual, and what will the ultimate recovery look like. Suffice it to say, the level of uncertainty is at historic and epic proportions.
The equity market’s drop was the fastest on record, with commentary comparing it to the 1930s and other major crises. Following the February 19 peak, equities fell 35%, interest rates fell to record lows, and corporate bond yield spreads widened instantly, pushing absolute yields significantly higher and prices lower.
In response, the Federal Reserve dropped rates a total of 175 basis points in two secret unscheduled meetings, creating some of the initial market volatility. Market liquidity for all other fixed income assets disappeared, driving prices down significantly. The selling even impacted ETFs that hold the highest quality and lowest risk assets, causing them to trade at a significant discount to their actual value. The Fed followed up the rate drops by unleashing a program to provide liquidity to markets including QE infinity (the ability to purchase an unlimited amount of US Treasury, mortgage, and even corporate bonds) and a lending program secured by all levels of collateral, ballooning their balance sheet to over $5 Trillion, with the likelihood that it will increase from there.
On the Fiscal side, three packages totaling over $2 trillion were passed to provide funds to individual citizens, as well as small, medium, and large businesses, including particularly impacted sectors. There are additional packages being created. We view these monetary and fiscal packages as “rescue” packages rather than stimulus packages. The fiscal package provided for added liquidity into the market, helping corporate and mortgage backed securities to begin to recover, and equity markets to rebound.
As the virus continues to spread, many are looking for the peak and plateau of new cases, to indicate the beginning of the end to the economic crisis. The market has responded to signs of a peak, and those signs coupled with the fiscal and monetary stimulus, have resulted in a rebound of about 25% off the March 23 lows.
There is a risk that the market has gotten ahead of itself as the return to “where we were” will take some time. The reopening of the economy will be gradual, and may require widespread testing, which is currently unavailable. The Fed is providing more than enough funding to support and propel the equity market higher. The question over the next number of months is whether or not corporate earnings and the broader economic fundamentals will support it.
We have evolved our investment strategy as quickly as the conditions have changed. As we stated early on, the broader the spread and the longer the duration of the economic shut downs, the greater the risk of permanent economic damage. The shut downs in the US and abroad have been more significant than our original expectations, and they continue to be extended. At the same time, the monetary and fiscal response has been enormous, and will support markets and financial assets for some time.
As we stated previously, the government programs are about solvency and liquidity, not profitability. As a general theme, it makes us more constructive on creditworthiness than profitability for now. The effect on interest rates remains to be seen. What we do know is that there are many solid corporate balance sheets whose bonds provide significantly more yield than the risk of nonrepayment implies. With respect to equities, we are coming into earnings season and the central themes will be halting stock buy backs, lack of forward vision and pulled guidance, and potential cuts to dividends to preserve cashflow.
From a macro basis, we previously had allowed profits to run as markets reflected the fulfillment of our expectations of the US economy. In the current situation we have worked to rebalance equity allocations back to neutral by harvesting gains as the market hit our targets. We have not yet rebalanced back to neutral by buying equities, but we have rotated within our holdings to add to new holdings that have become attractive.
Away from the general macro theme, within the economy there will be sectors and companies that will benefit, such as technology and consumer staples, as well as, those that will suffer significant damage such as energy and travel. We have established a “new era infrastructure” approach to identify those sectors and companies that will benefit going forward, differentiating “temporary” beneficiaries from long term beneficiaries. Our approach is to rotate portfolio positions into attractive areas from both a macro (top down) and micro (bottom up) basis. We will focus on individual sectors and companies, and less on broad market exposure.
Some of the trends in place, such as the diversification and reestablishment of supply lines away from China, stemming from trade talks last year will accelerate given the further disruption and the origin of the coronavirus. As such, we expect an acceleration of onshoring of production. Also, working and communicating remotely was a growing trend in place, that is now accelerating as “Zooming” has become an everyday activity. Online shopping and grocery/meal delivery had already accelerated, but this event has shown those whose previous investment in online infrastructure, allows them to truly compete. Of course, new medicines and devices will need to be researched, invested in, and produced in volumes, to address this new world with all the coronavirus implications. While there has been quite a run on toilet paper and other household goods, the excess demand of some items may prove to be temporary, with the exception of sanitizer.
Looking back at the first quarter, the winners were any company or sector that could benefit from home confinement – food, household staples, and work-from-home type technology. The losers were the travel industry and large purchases such as automobiles. These losers, together with the virtual shut down of production, halted the demand for oil, driving prices to the low $20’s. Treasury securities were the strong performer, while corporate bonds took extraordinary mark to market losses. The most significant loser is the small business such as restaurants and service providers, as well as the millions of workers in those businesses. The outstanding question as we recover from the episode, is whether the cashflow bridge being provided by the rescue package will keep those finances whole, to enable them to pick up where they left off. Plus, it is still unknown how quickly consumers will return to their previous consuming ways.
Throughout the past couple of years, our view has been that spending and investment in technology will be the driving force for spending and investment over the next number of years. This view has not changed, and many of our existing holdings are well suited for the future. The technology of faster and more broad-based processing and storage related to cashless transactions is core to economic growth. Also, the faster processing of information and worker mobility to be able to connect from anywhere, will increase demand for computing, as well as, the hardware and software that is needed. The national and global shutdown that has impacted our economy today, will turn the migration into an acceleration of the effort to automate and live remotely. Broadly speaking, corporate America maintains a strong balance sheet and should weather the storm, and corporate bonds that were punished amid the liquidity event, provided an opportunity to add high quality high income to portfolios.
Although there are many short-term uncertainties, there are also long-term growth opportunities. However, we need to be patient as it is difficult, if not impossible, to estimate the degree of the near-term damage to the economy, or the length of time it will take to come back on line. Your risk allocation takes into consideration your investment timeline, liquidity needs, and goals factors in this timeline. Given your allocation, our investment strategy seeks to provide the benefits of attractive income and long-term growth opportunities.
This pandemic has hit everyone in different ways – financially, physically and mentally. We sincerely hope that during this chaotic time, you and your families are safe and healthy, and that Covid-19 will soon be a distant memory for all of us. Our team is always here to listen to your concerns and answer your questions.
Neil J Powers, CFA